Venture capital is making a comeback

The year 2013 will be one of climbing out from a long era of darkness for venture capital. After all, you have to go all the way back to 1999 to find a time when VC earned market-beating returns.

Here's how dark things have been. The National Venture Capital Association has made available an analysis by Cambridge Associates of the internal rates of return for the average venture-capital fund that normally has a 10-year life.

Simply put, VC has been under-performing the average stock index since venture returns peaked in 1999. In the decade ending in 1999, the average VC fund generated a whopping internal rate of return of 83.4 percent. By 2010, the typical VC fund was a big money-loser, generating an internal rate of return of -5.2 percent. But by mid-2012, the typical VC fund had recovered to generate a positive internal rate of return of 5.3 percent.

In the past two years, I have interviewed about 200 entrepreneurs from venture-backed companies. From what I can tell, issues such as a possible recession, rising raw-material costs and unstable capital markets that seem to bother big companies do not seem to trouble many startup chief executive officers. What keeps them up late is worrying about how they'll turn their vision into a reality. But they don't see macroeconomic forces as the impediment.

They are concerned with keeping enough cash in the till to pay their suppliers and their people. For that, they rely on a ladder of cash sources: Customers who pay enough for them to make a profit; suppliers who extend generous payment terms; their own frugality when it comes to items that don't add value to customers; and the generosity of friends, family, angels, and venture capitalists, many of whom can be supplying cash at the same time.

The capital is mostly for paying talent chart-topping salaries. In its absence, they must mint their own emotional currency to continue hiring and motivating their industry's top stars. Given the war for talent, this means startup CEOs are concerning themselves with how to craft a vision that persuades the best job candidates that they will be missing out on a great opportunity unless they join their startup.

And in the last several years the war for that talent has intensified because so many individual investors have become fabulously wealthy in the last few years. According to a startup CEO I interviewed on Dec. 20, these wealthy investors have been pouring seed capital into startups at the earliest stages of development without sufficient discipline. These investors expect only one in 10 of these companies to succeed. But the availability of the seed capital is driving up the salaries of top technical talent.

And that means entrepreneurs cannot compete for that talent unless they can pay top dollar and offer a compelling mission. Not only that, but the rise in seed capital has been accompanied by a plunge in the availability of Series A funding. This means that unless a startup can become cash flow positive after using up its seed capital, it will struggle to get the next stage of funding, checks in the $5 million to $10 million range.

Silicon Valley insiders will be looking at the tea leaves in closely watched indicators including the upcoming quarterly NVCA reports, new products being demonstrated at trades shows such as the International Consumer Electronics Show, and the possibility that Washington will pass the Startup Visa legislation.

I think if there are any ground-breaking surprises at CES or other trades shows, venture investors could be motivated to place more capital in those companies.

If the NVCA reports show VC fund internal rates of return of higher than 8 percent, I think it will be easier for the funds to go to their limited partners and raise fresh capital. And it would be particularly useful for entrepreneurs if those reports show high single-digit returns for Series A investors.

The Startup Visa Act introduced in the U.S. Senate in 2010 would create a new visa for immigrants who can raise $250,000 for a startup company. Another possible legislative change would be to expand the existing EB-5 visa program for immigrant investors.

If these changes happened, the supply of talent would rise and startups would be better off.

Winners in 2013 will be owners of enterprise information technology companies that go public, while losers will be those who bought consumer Internet companies at their initial public offering prices and investors in clean tech.

Startups in enterprise IT are also more likely to come out ahead, whereas startups in the consumer space are likely to have a harder time getting funding.

For example, SugarCRM, an enterprise software company, is expected to go public in 2013. And if it follows in the footsteps of another enterprise software IPO winner, Workday, an enterprise software-as-a-service provider whose stock popped from $28 to $50 on its first day of trading in early October and is now at $55, more such startups will go public in 2013.

It's the consumer-tech companies that seem to be having more trouble. As of Dec. 20, people who bought Facebook, Groupon and Zynga at their IPO prices are underwater to the tune of 11 percent, 81 percent and 75 percent, respectively.

An NVCA survey of 600 entrepreneurs and venture capitalists conducted between Nov. 26 and Dec. 7 reveals that many believe a shift in VC investment is under way that will benefit some sectors and hurt others.

More specifically, capital is expected to flow into startups that provide information technology to businesses. More specifically, 61 percent of respondents expected increased investment in business IT, while 57 percent predict a rise in investment in health care IT.

Consumer IT investment appears to have peaked out, with only 35 percent of respondents expecting an increase in that field. But pessimism reigns for investment in other sectors.

The coming year promises to be a mix of old and new for VCs. For the old, entrepreneurs will execute on strategies to boost market share, raise capital and attract top talent, while VCs will try to maintain their slow upward trajectory after more than a decade in the desert. The new success will depend on whether VCs are right in predicting that enterprise IT will generate high internal rates of return after disappointments from consumer Internet, clean technology and medical devices.

Peter Cohan of Marlboro heads a management consulting and venture capital firm, teaches business strategy, and is the author of 11 books – most recently, “Hungry Start-up Strategy: Creating New Ventures with Limited Resources and Unlimited Vision.” His column runs Sundays and Wednesdays on telegram.com. His email address is peter@petercohan.com.

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